The Bubble Sitters: Dean Baker

Dean Baker, a macroeconomist and a believer
in the scientific method, is so confident that a housing bubble exists that he
is performing an experiment on himself.

In May 2004,
Baker and his wife sold their two-bedroom condominium in the Adams Morgan neighborhood
of Washington, D.C., and rented a similar unit a couple of blocks away. They owned
the condo for seven years and almost tripled their money.

As co-director
of the Center for Economic and Policy Research, a liberal-leaning think tank,
Baker has been warning
about a housing bubble for years. Scientists welcome disagreement as a way to
improve knowledge, and Baker has invited debate: At the beginning of 2004, he
sponsored a $1,000 essay contest to solicit the most convincing argument against
the existence of a housing bubble. CEPR posted the winning
essay by economist Hilary Croke, along with a rebuttal by Baker.

Decision
to sell
A few weeks after the essay contest, Baker sold his condo. He doesn't
characterize his decision to sell and rent as an experiment, but that's
what it looks like: a financial, clinical trial with Baker as his own
subject.

Dean
Baker

Bought:

$160,000
in 1997

Sold:

$445,000
in May 2004

Appreciation:

178
percent in 7 years; $285,000 gain

Rent
condo for:

$2,200 a month

Sold
because:

Was convinced that a popped bubble was inevitable

When Baker listens to the housing market, he hears an echo
of the tech-stock bubble of the late 1990s. The housing bubble will pop
a lot louder, he thinks.

"People lose sight of things," he says. "If
you go back to '98, '99, I was talking to people who said price-to-earnings ratios
don't matter anymore. They were just saying kind of nonsense. You get a similar
sort of mentality today with the housing market."

The
rental ratio Houses have something similar to a stock's price-to-earnings
ratio: their rental value. In a sane housing market, Baker says, a home's annual
rent is roughly one-14th of the home's value. So if a house is worth $140,000,
the annual rent should be around $10,000, or $833 a month. That's not a hard-and-fast
rule; the proper ratio depends on the level of property taxes and whether utilities
are included in the rent.

Baker says the rent-to-value ratio
is out of whack in his neighborhood. The annual rent he pays on his condo is roughly
one-17th of its value -- and that's not taking into account high property taxes.
Add those to the equation, plus condo association fees, and the ratio is closer
to one-20th.

"If you look back through the postwar
period, you find two things," Baker says. "One, house sale prices have
moved pretty much in step with the overall rate of inflation, and two, they have
pretty much stayed in step with rents." But sale prices have outpaced overall
inflation and rents in the last eight years, he says.

Baker attributes the swift rise in home prices to bubble psychology in which buyers
don't ask whether a home is worth $500,000 to themselves; instead, they predict
that the house will be worth $600,000 to someone else in a year or two or three.
They look at the house primarily as a quickly appreciating investment and secondarily
as a place to live.

Baker's contrarian
view
Baker has the opposite mentality: He wouldn't be surprised if prices fall
by one-third in his neighborhood. He doesn't know what will trigger the
bursting of the bubble -- he's not even sure what burst the tech stock
bubble in 2000 -- but one possible detonator is a rise in long-term mortgage
rates. He thinks prices might fall if long-term rates hit 6.5 percent
or 7 percent. (Right now, in August 2005, the 30-year fixed-rate mortgage
has an average rate of about 5.88 percent, and housing economists don't
expect it to hit 6.5 percent for a long time.)

Baker bought his condo for $160,000 in 1997 and sold
it seven years later for $445,000. His rental condo is comparable, and he pays
$2,200 a month.

If he were to buy the condo with a 5/1 hybrid
ARM at 5.5 percent, his principal and interest would be about $2,500 a month,
taxes would add about $200, and condo association fees would tack on another $400
to $500 a month. It costs him $2,200 a month to rent and it would cost upwards
of $2,800 a month to own, plus any maintenance and repairs he would be responsible
for. Even with a mortgage interest tax break of about $500 a month, he comes out
ahead by renting.

'I could be wrong'
He would prefer to own if it made financial sense. "I expect we'll probably
end up buying again, but only when prices adjust," Baker says.

This brings up a delicate question: Baker is a morally serious man. Did he have
ethical misgivings about selling his home at what he believes to be an inflated
price?

"I don't feel any qualms about this,"
he says. "I've been jumping up and down, yelling, 'There's a problem here.'
I've done everything I can to publicize it and warn people. I don't know what
else I could do. I didn't feel good about it. But this guy was going to buy a
place. If he didn't buy my place, he was going to buy someplace. I could be wrong.
I don't think I will be."